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Thursday, March 10, 2011

Vestin: Bad Loans, But Worth Something

Prior to the recession, a lot of reckless loans were made. And while a lot of loans that were secured against real estate lost a lot of value, they usually didn't become worthless. But sometimes the market treats them as such, much to the delight of value investors. For example, Quest Capital traded at a large discount to book value not long ago, and the value was eventually realized as the cash started rolling in. Today, a similar opportunity may exist with Vestin Realty Mortgage I (VRTA) and Vestin Realty Mortgage II (VRTB).

It's worth looking at the companies together for several reasons. First, they have the same manager. Second, they are similar companies, often lending to the same entities. They also trade at similar discounts to book value, and for some reason they own shares of each other, in a Japanese-style cross-holding. And last but not least, it appears that they may soon merge in a stock for stock deal.

Together, they have about $21 million in cash, $29 million of real estate held for sale, and real estate loans receivable of $37 million (for a total of $87 million) against liabilities of $15 million. But combined, these companies trade for just $28 million, representing a massive discount to book value.

The large discount can likely largely be explained by the companies' record when it comes to loan losses. Book values have fallen by a combined $40 million (mostly as a result of write-offs) or so in the last year, suggesting the company was downright reckless with its loans prior to the recession. But loan losses appear to have decelerated significantly; last quarter, the companies combined for minimal write-downs, though they are still losing money.

It is these consistent losses that may be the biggest risk to shareholders, because of management's incentive structure. The companies' CEO is also the owner of the companies' management company, which is bad news for shareholders. This structure encourages the CEO to keep the companies running (even at a loss) so that they can keep paying fees to the entity which he owns.

To that end, the company has not been clear about what it plans to do with its substantial cash holdings and the cash that is generated from sales of its real estate that is held for sale. I did try to speak to management to get some clarification on this issue, but I was told to try again after the release of the 10-K.

We've seen situations in the past where companies such as this one have generated substantial returns for shareholders who invest at large discounts to book value. However, there are several differences here that make this far from an ideal example. The incentive structure, the particularly poor lending record, and the lack of candid communication about future actions should give investors pause despite the massive discount to book value.